The last four years have shown a link between gentler deficit reduction and economic growth, so why is the Chancellor not taking notice?
In his first Budget in 2010, George Osborne announced an increase in VAT from 17.5% to 20% and a tough set of spending cuts, which were implemented over the next two years. In 2011 and 2012, economic growth disappointed.
After two years of poor growth, the Chancellor relaxed the pace of fiscal tightening. There were no more tax increases – and some tax cuts – and public spending was cut less aggressively. Between 2013/14 and 2014/15, cyclically adjusted public sector borrowing is actually expected to increase from 4.1% of GDP to 4.2%. In 2013 and 2014, economic growth has picked up to a healthy pace.
This inverse correlation between the pace of deficit reduction and growth in the economy should not come as a surprise; it is what happens when interest rates are at the ‘zero lower bound’ (in other words, at a level below which they cannot be cut). When this position is reached, there is very little monetary policy can do to boost economic growth. Quantitative easing was tried and probably had some effect, but it was last increased in July 2012.
Over the next few years, according to today’s Autumn Statement, the Chancellor is planning to step-up the pace of deficit reduction again. Cyclically adjusted public sector borrowing is projected to fall from 4.2% of GDP in 2014/15 to 1.8% in 2016/17; and to be eliminated by 2018/19.
This is despite the fact that interest rates remain at their zero lower bound.
If the economic outlook was very positive, or if there was a risk that the government might have difficulty financing its debt, it might be possible to justify an increased pace of deficit reduction, but this is not the case.
There has been some good news for the UK economy in the form of the recent plunge in oil prices. This reduces costs for industry and, crucially, eases the squeeze on household budgets by lowering energy prices and the cost of petrol. Consumer spending might, therefore, be stronger than otherwise expected.
But, as the Chancellor said in his statement, ‘warning lights are flashing over the global economy’. Growth in the euro zone has come to a virtual standstill and even China is growing less rapidly. The UK economy’s recent export performance has been poor and there seems little reason to expect an improvement.
Overall, therefore, the economic outlook is uncertain. Perhaps not quite as uncertain as it was in 2010 – but enough to merit caution over an aggressive tightening of fiscal policy.
Meanwhile, there is little to suggest that financial markets are unwilling to hold UK government debt. Currently, the government can borrow over 10 years at a rate of just 2% – suggesting a real rate of zero if the 2% inflation target is achieved.
The lesson of the last four and a half years is that aggressive cuts in the government’s deficit are likely to be associated with weaker growth; more moderate cuts with healthy expansion. It appears, however, that the Chancellor has not learned this lesson, because he is planning to step-up significantly the pace of deficit reduction over the next few years. If he – or any successor after next year’s election – follows through with these plans, it will mean taking a big risk with the economic recovery.
Tony Dolphin is chief economist at the Institute for Public Policy Research
